Shadow banking: the Chinese problem

Instead, it broke with tradition and did nothing to preserve stability, allowing the Shibor to soar and causing the stockmarket to suffer massive falls.

This unexpected lack of action caused widespread predictions of a crackdown on the ‘shadow banking’ sector, involving tough reforms from China’s new government, which came in four months ago.

Mark Williams of Capital Economics explains: “The episode is arguably the strongest sign yet that the leadership is willing to suffer short-term economic pain ... to achieve more sustainable growth.”

So is shadow banking to blame for stalling one of the world’s fastest growing economies? And is the sector really as dodgy as its name suggests?

What is shadow banking?

A shadow banking system is made up of financial intermediaries that facilitate the creation of credit but are not necessarily subjected to regulatory oversight, and what economists describe as “unregulated activities by regulated institutions”.

In Europe and the US, an example of the former would be hedge funds, and an example of the latter would be credit default swaps. In China, however, shadow banking can include simple, low-risk financial vehicles, such as cash accounts held within mutual funds.

“Shadow banking is really anything you want to make it,” says Philip Ehrmann, manager of Jupiter China. “It’s basically a catch-all expression that reflects the unreformed state of markets, such as consumer credit in China, and includes anything that is not a conventional bank account or loan.”

When did shadow banking in China start?

Conventional banks undertook the vast majority of all lending in China until 2008, when the global financial crisis started to hit export-driven Chinese firms.

At that point, the Chinese government enacted a stimulus package worth $586bn (£387.5bn), more than half of which was financed through new bank lending, thereby flooding the economy with cheap credit.

While this helped to prop up the economy at the time, it also fuelled a speculative housing market bubble and a local government debt problem caused by the municipal government-owned companies that received the bulk of the cash.

“People have been worried about local government finances, because they do not want the sort of economic meltdown seen in the West,” Mr Ehrmann adds.

In 2009, the Chinese government stopped the flow of money, meaning banks had to find credit elsewhere.

Wealth management vehicles that allowed the banks to refinance bad loans and keep lending off the balance sheets started appearing, and China’s shadow banking sector – which KPMG now believes is the country’s second-largest financial sector – was born.

With individual savings levels high in China, and wealth management vehicles providing higher returns than conventional savings accounts, the appetite for this type of product is unlikely to disappear overnight.

Moves by the government and the central bank to control and reform the sector are therefore more likely to result in the regularisation of shadow banking than a return to the old ways.

Could shadow banking cause an economic crisis?

Ratings specialist Fitch believes China’s shadow banking sector may be hiding risky assets worth as much as $2trn (£1.3trn) in off-balance sheet lending.

While that is a huge amount, Mr Ehrmann does not expect China’s banks to face the same problems UK banks did five years ago.

“Provisioning for non-performing loans has been high. But if you look at the figures for actual non-performing loans, the percentage is less than 1 per cent,” he says.

Richard Gao, portfolio manager at Matthews Asia, agrees that Xi Jinping’s government will not allow shadow banking to trigger a full-scale crisis.

“We believe that a widespread banking crisis seems unlikely for China,” he says, but adds that there could be further knock-on effects on the economy.

“If the interbank interest rate remains high for an extended period, it could ultimately lead to higher financing costs for businesses, harming the growth of China’s already slowing economy.”

The PBoC’s announcement that it has since provided some liquidity to support financial institutions “in prudent need” – and the subsequent fall in the Shibor rate – are therefore welcome signs.

“The relatively tight liquidity may still exist for some time, but it seems its peak may be behind us,” Mr Gao concludes.

Jessica Bown is a freelance journalist